The Fed Signals a Slowdown; Traders Head for the Exits

By

Tom Lauricella

June 22, 2013 8:26 p.m. ET

The sharp selloff in the bond market is a wake-up call for investors. But in some cases, it's also an opportunity.

Many bond market funds are now showing losses for the year: Yields have jumped sharply, and prices correspondingly have fallen, because the Federal Reserve seems increasingly likely to scale back its efforts to stimulate the economy.

But more broadly, sharp selloffs in higher-yielding investments have revealed where investors may have overpaid for those income streams. That was especially the case in high-dividend stocks, such as utilities, which many investors tend to view as havens. Also taking a big hit: yield-rich real-estate investment trusts.

ENLARGE

Jason Schneider

This abrupt shift in recent weeks highlights the importance of having at least part of a portfolio positioned for rates making a sustained rise. That could include owning go-anywhere bond funds whose fate isn't linked to rates staying low.

But at the same time, investors may have, in some cases, thrown out the baby with the bathwater. Some pros say corners of the market which took a hit are now attractive—such as high-yield bonds and energy-focused master limited partnerships.

The bond market selloff has been swift. Yields on the U.S. Treasury 10-year note, which move in the opposite direction of prices, have jumped from 1.6% in mid-May to 2.5%—their highest level in 15 months.

ENLARGE

By historical standards, yields are still quite low, but the market move has been painful: Forexample, the $15 billion iShares Core Total U.S. Bond Market ETF (AGG), which tracks the widely followed Barclays U.S. Aggregate Bond Index, is down 2.5% for the year, wiping out the 2.2% annual yield the fund offers, according to Morningstar.

Driving these moves has been a rethinking of the future course of Fed policy. With the U.S. economy showing moderate growth, Fed officials have suggested that they could pare back their $85 billion-a-month bond-buying program later this year.

Fed Chairman Ben Bernanke last week compared the potential scaling back of its easing to lifting a foot off the gas pedal of a car.

Yet it was more than enough to spook the bond and stock markets.

The Dow Jones Industrial Average dropped 200 points in the immediate wake of Mr. Bernanke's comments on Wednesday, shed another 350 points in Thursday's rout but clawed back 40 points on Friday.

The Dow closed down 1.8% for the week. It is down 3.96% from its all-time high mark, set barely a month ago.

This sudden shift in the landscape offers several lessons to investors who have flocked both to bond funds and to other investments that closely track bond yields.

There's a tendency among investors to think they can get out of their bond investments before the tide changes. But, says James Swanson, chief investment strategist at MFS Investment Management, "interest rates are notoriously hard to predict."

Shawn Rubin, a financial adviser at Morgan Stanley, notes that because of the math of how bonds are priced, at low yield levels, "it doesn't take a lot of interest-rate moves to wipe out returns."

Mr. Rubin thinks the recent market moves give investors a taste of what's to come over the next several years. So he is recommending funds that aim to generate positive returns even when interest rates rise.

Also taking a hit have been higher-yielding corners of the stock market that had benefited from investors looking to juice returns on their portfolios, such as utilities stocks and REITs.

Charles Lieberman, chief investment officer at Advisors Capital Management in Hasbrouck Heights, N.J., points to shares of Consolidated Edison(ED), the New York City utility yielding 4.3%, and Vornado Realty Trust (VNO), yielding 3.5%, as two examples of stocks that had big run ups thanks to yield hunters when Treasury 10-year notes were paying out less than 2%. In just the past month, Con Ed shares have dropped 5.8% and Vornado, 7.5%.

"The trade worked for a while, but people were taking a lot more risk than they realized," says Mr. Lieberman.

Mr. Lieberman thinks, however, that some yield plays have been unfairly tarnished.

Among them are master limited partnerships, otherwise known as MLPs, he says. Because of their structure, MLPs generally hand over all their profits to shareholders and those distributions usually aren't taxable until investors sell the shares.

Thanks to rising domestic energy production, "the wind is powerfully at their back," he says. "You're getting very good yield and a lot of growth ahead."

He points to Kinder Morgan (KMI), which is yielding 3.8%, and whose shares have fallen 6% in just the past month.

"The correction has been pretty big," he says. While these high-yield bonds had gotten pricey this spring, with the U.S. economy growing and default rates among below-investment-grade borrowers low, "I don't think the fundamentals have changed."

Mr. Mordy also thinks emerging-market bond funds have been punished too hard. With healthy fiscal outlooks in many emerging-market countries, "I'm not deterred by a little rattling in the bond market," he says. For emerging-market bonds, he likes the WisdomTree Emerging Markets Local Debt ETF (ELD), which provides exposure to both emerging-market bonds and currencies. That ETF is yielding 4.2% and has dropped nearly 9% in the past month.

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